Programme Area(s)

Abstract

We propose a novel, risk-based transmission mechanism for the effects of currency manipulation: policies that systematically induce a country's currency to appreciate in bad times, lower its risk premium in international markets and, as a result, lower the country's risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country (``currency stabilization''), we find that a small economy stabilizing its exchange rate relative to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target economy, offering a potential explanation why the vast majority of currency stabilizations in the data are to the US dollar, the currency of the largest economy in the world. A large economy (such as China) stabilizing its exchange rate relative to a larger economy (such as the US) diverts capital accumulation from the target country to itself, increasing domestic wages, while decreasing wages in the target country.